Fed acting with restraint

In the five months since the Federal Reserve started a campaign to increase growth and reduce unemployment, the economy has slowed and unemployment has increased.

The Labor Department said last week that the jobless rate rose to 7.9 percent in January, up from 7.8 percent in December, in the latest evidence that the economy still is not growing fast enough to repair the damage of a recession that ended in 2009. Some economists found the disappointing data an indication the Fed had reached the limit of its powers, or at least of prudent action. But there is evidence that the Fed is not trying as hard as it could to stimulate growth: It is allowing inflation to fall well below the 2 percent pace it considers most healthy.

Inflation, unlike job creation, is something the Fed can control with some precision. Higher inflation could accelerate economic growth and job creation by encouraging people to spend more and make riskier investments.

Yet annualized inflation fell to 1.3 percent in December, and asset prices reflect an expectation that the pace will remain well below 2 percent in the next decade.

“By their own framework, they're not doing enough,” said Justin Wolfers, an economist at the University of Michigan. “They said that they were going to expand the economy and keep inflation around 2 percent, and they just haven't done it.”

The rest of the government is making that task more difficult. Federal spending cuts, tax increases and the prospect of further cuts March 1 are hurting growth. Fed Chairman Ben Bernanke has warned repeatedly that monetary policy cannot offset such fiscal austerity.

And it is likely that the latest economic data does not reflect the full impact of the Fed's efforts. Despite the rise in unemployment, job creation has increased in recent months, consumer spending has strengthened and the housing market is healing. Partly because monetary policy is slow-acting, most forecasters expect modest growth this year.

But the Fed also is acting with a clear measure of restraint. Bernanke and other officials have made clear that they believe the central bank could do more to increase the pace of inflation and bolster growth and job creation. They simply are not persuaded that the benefits outweigh the potential costs – in particular, the risk that their efforts will distort asset prices and seed future financial crises.

The Fed is constrained in part because it has done so much. The central bank has held short-term interest rates near zero since December 2008, and it has accumulated almost $3 trillion in Treasury securities and mortgage-backed securities to push down long-term rates and encourage riskier investments.

Under its newest effort, announced in September and extended in December, it will increase its holdings of Treasurys and mortgage bonds by $85 billion a month until the job market improves. The Fed also said that it planned to hold short-term rates near zero even longer, at least until the unemployment rate fell below 6.5 percent.

In normal times, the Fed would respond to flagging inflation and growth by cutting interest rates. At present, it could still increase the scale of its asset purchases.

The two policies work in a similar way, stimulating economic activity by reducing borrowing costs and encouraging risk-taking. But asset purchases are a less direct method to reduce rates, and the available evidence suggests that the effect is less powerful.

The Fed's holdings of mortgage bonds and Treasurys are growing so large that they could begin to distort pricing in those markets, and some transactions could be disrupted by a dearth of safe assets. Some officials are concerned that asset prices for farmland, junk bonds and other riskier assets are being pushed to unsustainable levels. As a result, Bernanke said, the Fed is doing less than it otherwise would.

“We have to pay very close attention to the costs and the risks and the efficacy of these nonstandard policies as well as the potential economic benefits,” Bernanke said last month, in response to a question about the pace of inflation.

“Economics tells you when something is more costly, you do a little bit less of it.”

The Fed to some extent may be a prisoner of its own success in persuading investors over the past three decades that it was determined to keep inflation below 2 percent. It said in December that it would let expected inflation in the next two to three years rise as high as 2.5 percent. But expectations have not budged.

The Federal Reserve Bank of Cleveland calculated in a January report that average expected inflation over the next decade was just 1.48 percent per year.

Fed officials generally expect somewhat higher inflation, but their most recent predictions, in January, show that none of the 19 policymakers expected inflation to exceed 2 percent over the next two years.

Some experts note that the Fed could be trying harder. Bernanke and other Fed officials have been careful to say that they will tolerate inflation expectations above 2 percent while also insisting that it is not a Fed goal to push expectations above 2 percent.

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